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As Sam Sees It: The Dangers of "Yielding" to Temptation

Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

EQ: October is coming to a close, which means that investors in the know may be looking at the Best Six Months ahead. In your book, The Seven Rules of Wall Street, one of the rules is to "Sell in May, and Go Away." Is it time for investors to come back?

Stovall: History would suggest that it is a good time to come back. Of course, there is no guarantee that the coming six-month period will be a positive one or that it will be better than what we experienced in the last six months. But going back to World War II, the S&P 500 gained an average of 6.8 percent from November through April, but only 1.2 percent from May through October. Also, the November through April period outperformed the subsequent May through October period in two out of three observations. So purely from that perspective, then history does suggest the answer is, "Yes."

EQ: You've said that the market is most likely going to experience its usual year-end rally, but then has a strong possibility of re-entering a new bear market. Has the Q3 earnings season thus far reaffirmed your opinion or have there been any surprises?

Stovall: I am still calling this market a tale of two time frames. The fourth quarter has done very well so far, even though we're only four weeks into it. We entered the fourth quarter of 2011 in a very distressed state. The third quarter declined more than 14 percent on the S&P 500, and investor confidence was as low as it was back in March of 2009. So the implication was things could only get better, at least in the near term, and that the market might indeed undergo a counter-trend rally. Earnings have certainly contributed to that as well. The S&P 500 has seen 283 companies report earnings, and according to S&P Capital IQ, 68 percent of them have beaten their estimates while 21 percent missed and 11 percent have met the estimates.

In July, S&P Capital IQ estimated a 17-percent of year-over-year increase for the third quarter. But by mid-October, it dipped to as low as 12.4 percent. Now, however, it appears that Wall Street is making a 15.9 percent gain in third quarter earnings, which would be the eighth consecutive quarter of double-digit growth. Certainly, things have gotten a little bit better by the second week of October, but there's one thing out there that does cause a bit of concern. It is called the negative-to-positive guidance ratio. Of the 111 companies that have issued guidance, 34 are up and 64 are down, bringing the negative-to-positive ratio to 1.88. This is in comparison to the 1.33 that was seen in the first and second quarters of this year. What that implies is that negative guidance is a lot greater with Q3 than what we saw in the first two quarters.

EQ: So we've talked about investing in dividend stocks using the S&P's High Yield Dividend Aristocrats and your preferred process for screening quality companies. But in your most recent Sector Watch, you think that perhaps even these stocks are getting too expensive. Are investors overpaying for safety?

Stovall: The purpose of my article was to warn investors to not just think that a theme is going to make you money. Even if it sounds good, you still have to do your homework and make sure you're not overpaying for these companies. Several years ago when investors started focusing on yields, I said don't "yield" to temptation--pun intended. Simply put, you don't want to buy the highest yielding stocks without looking behind the curtain to see what causes them to yield so much, such as investors bailing out of the stock because they anticipate the yield to be cut. I was recommending that investors focus on companies that have a solid track record of raising their earnings and dividends over time. So, they should have an S&P Quality Ranking of A- or better, implying that these companies have had an above average consistency in raising their earnings and dividends in the previous 10 years.

With that said, we also have to be careful because if everybody is striving for dividend yields, then we end up with what's called a "very crowded trade." If too many people are chasing the same investment approach, then somebody is probably bound to be wrong. My recommendation was that while a good dividend paying stock is a rewarding investment going forward, just be sure that you don't overpay for it. Investors should not get carried away in search of just yield, but they also need to make sure that they look at the value and the cost of that yield as well.

So, using the screening capabilities of the S&P MarketScope Advisor, I filtered to see all of the companies that have a S&P Quality Rank of A- or better (implying above-average consistency of raising their earnings and dividends over the past 10 years) and a dividend yield of 3 percent or more, but then also with a S&P Fair Value Ranking (S&P’s quantitative investment evaluation technique) of Sell or Strong Sell. I ended up with 46 companies that met those criteria. From there, I whittled it down further by stripping away any of the companies that might have favorable qualitative investment opinions by S&P Equity analysts. I came up with 15 stocks that looked as if investors might want to consider avoiding, or at least realize that they might underperform other quality stocks that are less expensively priced.

EQ: Which sectors did you find were most at risk of being overvalued? What would you recommend investors do to avoid overpaying for dividend yields?

Stovall: Of the 15 stocks that came out of my screened criteria, Utilities had the greatest number with nine. There were five from Consumer Staples, and one each from both Consumer Discretionary and Information Technology. So two sectors that have done very well while this market has been through its gyrations since April 29--being Consumer Staples and Utilities--may be getting more expensive at this point and some of the stocks in these sectors may require a closer look before investors jump in and purchase additional shares in these companies.

EQ: That's interesting, because those are traditionally two of the safest sectors for investors.

Stovall: That is correct. I like to say that when the going gets tough, the tough go eating, smoking and drinking, and if they overdo it, they go to the doctor. Consumer Staples and Healthcare have been the two best performing sectors on a relative basis in recessions and bear markets since World War II. Utilities have been the third best relative performer, followed by Energy. Those four sectors have beaten the S&P 500 anywhere between 80 percent to 100 percent of the time in bear markets since World War II. But, of course, past performance is no guarantee of future results.

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